Why We Should Cut Deficits and What Should Guide the Process

by: Rortybomb

As part of a panel last week, the Roosevelt Institute issued a series of new working papers related to the deficit debate.

The first one is Principles and Guidelines for Deficit Reduction by Joe Stiglitz. It provides a set of guidelines for the purposes of reducing deficits and how to best proceed by using sound economic thinking.

These general principles have some direct implications, providing seven guidelines, which should guide proposals for deficit reduction as we strive for equity as well as effciency and growth.

1. Public investments that increase tax revenues by more than enough to pay back the principal plus interest reduce long-run deficits.

2. It is better to tax bad things (like pollution) than good things (like work).

3. Economic sustainability requires environmental sustainability.The polluter pay principle - making polluters pay for the costs they impose on others - is good both for efficiency and for equity.

4. Eliminating corporate welfare is good both for efficiency and for equity.

5. Given the increases in inequality and poverty and given the inequitable nature of the 2001 and 2003 tax cuts, the incidence of any tax increases should be progressive, and there should be no increases in the tax burden on the poorest Americans.

6. Eliminating giveaways of public-owned assets is a fair way of reducing deficits.

7. Eliminating distortions in tax and expenditure policies - with appropriate compensatory policies for lower and middle income Americans - can be an efficient way of reducing the deficits. Even if overall such tax expenditures are regressive, given the dire straits that so many poor and middle class Americans are in, eliminating those tax expenditures without appropriate compensation (e.g. in the reduction in tax rates on lower and middle income Americans) would be wrong.

He expands on these throughout the article, including adding smart and sensible things like this:

The Generalized Henry George Principle

One of the general principles of taxation is that one should tax factors that are inelastic in supply, since there are no adverse supply side effects.Land does not disappear when it is taxed. Henry George, a great progressive of the late nineteenth century, argued, partly on this basis, for a land tax. It is ironic that rather than following this dictum, the United States has been doing just the opposite through its preferential treatment of capital gains.

But it is not just land that faces a low elasticity of supply. It is the case for other depletable natural resources. Subsidies might encourage the early discovery of some resource, but it does not increase the supply of the resource; that is largely a matter of nature. That is why it also makes sense, from an efficient point of view, to tax natural resource rents15 at as close to 100% as possible. The well-designed auctions described earlier enable government to capture most of the rents derived from government owned assets.

Another paper out is by Thomas Ferguson and Robert Johnson, A World Upside Down? Deficit Fantasies in the Great Recession, which steps back to ask why we are concerned about deficits with unemployment hovering at 10% and the bond market not at all worried about lending to us. It also examines what our real threats are, and what is window-dressing and small-minnows:

We critically examine claims put forward by Rinehart and Rogoff, the International Monetary Fund, and others about the dangers of rising debt to GDP ratios. We also scrutinize assertions by Alesina and Ardagno that cutting deficits is likely to be stimulatory. Our analysis of the U.S. budget outlook leads to surprising conclusions. We highlight the unheralded acknowledgement by the Congressional Budget Office in August, 2010 that financial assets held by the government should be netted out of U.S. debt calculations. This step takes the U.S. further away from any hypothetical danger zone and should be a yellow flag to shrill warnings of danger from U.S. deficits.

Our analysis of threats to the budget finds that not entitlement spending or Social Security, but the excessive costs of oligopoly in health care and defense spending play a large role in current concerns. So does the contingent liability of another financial crisis. In an era of unbridled money politics, concentrated interests in the military, financial, and medical industries pose much more significant dangers to U.S. public finances than concerns about overreach from broad based popular programs like Social Security, which is itself in good shape for as many years as one can make credible forecasts.

The paper also examines two hypothetical scenarios: One involving a growth inducing public investment program and another, more pessimistic scenario in which underemployment equilibrium is allowed to persist for several years. From those scenarios we conclude that the risk to U.S. public finances, as measured by the debt/GDP ratio in 2020, is much greater on a trajectory of austerity than from any risk incurred by the very low public cost of borrowing to spur investment in infrastructure, education, and science that would generate large social and private gains in productivity.

They also walk through the debate from Reinhart and Rogoff, the IMF, the austerity-growth crowd, and about how bad debt can get before growth slows with new data about England going back to the Industrial Revolution:

Consider this chart:

Click to enlarge

The point can be put even more forcefully: the U.K. made its epochal breakthrough to industrialization – leaving the rest of the world far behind – while carrying a debt load that should have crushed it, not only in the eighteenth century, but many decades into the nineteenth. And it was precisely as the debt to GDP ratio soared that the rate of growth finally picked up. Of course, British debt levels through most of the twentieth century remained almost as high because of expenditures run up for World Wars I and II.

Rob Johnson made a great point at the panel for this paper that as a bond trader, most of what is passing for deficit reduction wouldn’t register on his radar. This includes Social Security. Most of what would be reduced a rational bond trader, looking at the United States political economy, will likely end up as tax cuts for the rich or defense and health care spending. Social Security and the Smithsonian are minnows; defense, health care and the political economy of the rich are the bond trader’s whales. And the difference between a bond trader who makes it rain and one who gets fired is the ability to tell the difference.

Before you get sucked into crisis thinking, it is worth stepping back and actually thinking through why we should cut deficits, under what circumstances and with what tradeoffs in mind we should cut deficits, and what should guide us in the process. These two papers answer these questions.